Direct Cost as a Relevant Cost

Direct costs may be directly chargeable to a cost center or a product. They may be fixed costs or variable costs whereas it comes to decision-making.

Illustration

A summary of the loss and profit reported in every of three product lines B, C, and D is given as:

Required

1. Comment on the financial condition like presented in the above summary

2. Comment on a decision to discontinue product C whereas

a) 60 percent of the fixed costs charged to it relate to advertising of product C and are avoidable if discontinued OR

b) All of the fixed costs charged to product C are ignorable if discontinued

3. Discuss whereas product D must be discontinued if

a) 90 percent of the fixed costs charged to it are company costs arbitrarily apportioned to it or

b) Eliminating of its variable cost would result in an raise in material cost for products B and C since of lost discounts that would have the effect of increasing their variable costs by 5 percent OR

c) Products B and D are complementary products whose sales demand is directly concerned to that of each other

Solution

1. The existing figures illustrate that products B and C are making a contribution towards fixed costs where product D is in a negative contribution condition. The cash out flow directly concerned to product D are not paid for via the cash inflows from sales revenue. Product B demonstrates a net profit of Shs. 5000 whereas product C demonstrates a net loss of 2000. The question data has not shown whether the fixed costs allocated to each product are an arbitrary apportionment of the net company fixed cost

2. a) Where 60 percent of the fixed costs charged to product C relate to advertising of the product and are ignorable if it is discontinued, it is earning a net margin or net contribution of Shs. 10000 - (60 percent x Shs. 12000) = Shs. 2800. It means that Product C is contributing to the net cash inflows of the company and should be retained in the short term if no more profitable employ of the capacity if available

b) Where all the fixed costs charged to product C are avoidable if it is discontinued, it means that they are directly attributable to product C. the net loss of Shs. 2000is a true measure of its effects on company cash flows. If the position cannot be better the company will save Shs. 2000 in the short term via discontinuing product C

3. a) Product D has a negative contribution of Shs. 2000, if 10 percent of the fixed costs charged to it are directly attributable to the product this adds a further Shs. 1000 (10 percent x 10000) to its adverse effect on company cash flow

b) The variable costs of products B and C would raises by 5 percent if product D is discontinued

Raises in cost of products B and C = 5 percent x Shs.40000 + Shs. 30000) = Shs. 3500

Savings with discontinuing product D  = Shs. 2000

Net benefit of retaining product D = Shs. 1500

In this condition the discontinuance of product D will result in total loss to the company of Shs. 1500 since the increased costs of products B and C as loss of discount

c) If products B and D are complementary products, their position should be examined. If product D is discontinued it means that product B sales will be lost. Product B currently earns a contribution of Shs. 20000 that far outweighs the negative contribution of Shs. 2000, such results from product D. Both products should be sold and produced.